Strategic Costing
The strategic costing process consists of four steps: estimating the cost of a supplier's product or service; estimating the cost of a competitor's product or service; setting your company's standard costs and identifying areas of improvement in your products and processes; and determining what it is worth to your company to make these process and product changes and make continuous improvements.
Using this four-step process helps answer the following questions: Should my organization expand its production capabilities? What are the strengths and weaknesses of my competitors? What strategies will give my business a head start on the competition? How will this process affect your company's bottom-line earnings and cash flow?
1. Estimate the cost of the supplier's product or service. Much useful data can be obtained by visiting the supplier's facility, observing and asking appropriate questions to estimate the supplier's costs. Remember, to estimate the supplier's costs, you must know the materials used in the product, the number of operators who make the product, and the total investment in all the equipment directly used in the production process.
Take a team tour of the supplier's facilities. The team should consist of at least three people, including one from each of the three key departments: engineering, purchasing and production. Prior to the tour, team members should meet to determine the roles each person will assume and the focus of the tour. Each person is assigned a cost driver, one of materials, total investment and labor, and gathers as much information as possible on that driver.
Since the engineering person is likely to be the most familiar with the equipment, he or she is usually assigned to learn about all the production equipment used and the suppliers of that equipment. The purchasing person is tasked with gaining an in-depth understanding of the materials used for manufacturing. The production person, on the other hand, is usually the one who "counts heads," and he or she must understand the production process and the staffing levels.
After estimating supplier costs and understanding where the most costly areas are, you can plan a price negotiation that will allow you to make a profit. How? Work with suppliers to reduce the most heavily weighted costs, thereby reducing your organization's material costs and improving bottom-line revenue.
Always strive for a win-win situation. This means trying to get the best possible outcome from the negotiation that is favorable to both parties. If you're trying to build a long-term relationship with a supplier, you can't afford to push them to the point of losing money in negotiations. At the same time, you can't allow yourself to concede too much.
2. Calculate the cost of competitors' products and services. Estimates of competitors can provide the information necessary for your company to take the initiative in the marketplace. This preemptive stance keeps companies at the top of their industry and ultimately keeps them profitable and viable for a long time.
Competitive assessment doesn't just mean aiming to benchmark your industry peers. It means making a careful study of competitors' operations, investments, costs, and cash flow, and anticipating their strengths and weaknesses. This information may not be easy to come by, but it will enable you to make sound business decisions and keep your organization competitive and at the top of the pack.
Patents contain a wealth of information. There are two main pieces of information you can usually glean from a patent: the materials used and the manufacturing process. With information from patents, plus an understanding of the manufacturing process, your company's engineering staff can prepare flow charts and make estimates of the replacement investment in manufacturing equipment.
Market segment overviews, company financials, executive profiles, and corporate histories can also provide you with a wealth of information about your competitors. By consulting business magazines (especially their annual issues) that contain information such as key sales figures and markets, you can gain an understanding of the market. Once you are confident of this information, you can calculate the cost of competitors' products and services.
3. Set your company's target costs and identify areas for improvement in products and processes. Before you can start to identify areas that need attention and implement improvements to your cost profile, you need to estimate your competitors' costs and compare them to your company's actual costs.
For example, a competitor's strengths are in materials, labor, and overhead costs. They are able to achieve costs of 70 cents per pound for materials, 40 cents per pound for labor, and 30 cents per pound for administrative costs. Your company's best strategy is to develop a plan to improve in these areas. If your plan is having trouble working, or if you don't believe the business can significantly reduce these costs, then perhaps the best strategy is to make no investment in research and development.
What does it mean for you if your competitors' weaknesses are in the areas of utilities, maintenance, depreciation, property taxes and insurance premiums? These areas are directly related to total investment. Competitors must have a higher level of automation or more streamlined processes than you do.
Strategic costing requires you to identify areas for improvement, analyze the effort required to achieve them (investment and time), and calculate the value to the business of achieving those improvements.
4. Determine the value to the company of making these process and product changes and continuing to improve them. Any changes the company is considering making can be viewed in terms of both short-term and long-term effects. To discover the long-term effect of your proposed changes on the financial position, look at cash flow. Cash flow gives you a better view of the big picture than net income alone.
Cash is as important to a business as blood is to the human body. If the cash outflow is greater than the inflow, the business will not be healthy and may even die. Cash "shortages" are especially common among small businesses, which typically don't have large cash reserves. Cash flow analysis can be used to determine the health of a business and to develop a financial plan.
Cash flow is the amount of money coming in to a business minus the amount going out. The primary source of cash inflow is sales revenue. Cash outflows are all necessary cash expenditures for operating the business, purchasing new fixtures or equipment, and paying taxes. Cash expenses also include labor, utilities, and maintenance.
By calculating annual actual or projected cash inflows and outflows, you can develop a plan to keep your company's finances running smoothly. And by forecasting the cash flow of your business and your competitors, you can see how the effects of strategic planning are reflected in your finances.
These rules apply to all businesses in today's market. Businesses can only win lasting prosperity if they are strategically at the forefront of cost control, reduce costs, understand their competitors, and make smart decisions about scaling up and even down.